Why is it so hard to close the budget gap

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Budget Basics (4): Why is it So Hard to Close the

Budget Gap?Post prepared June 30, 2010

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Closing the Gap: Saying It vs. Doing It

Previous items in this Budget Basics series show that the US budget deficit and debt are unsustainable in the long term

It is easy to say how to close the budget gap—cut spending or raise taxes. So why is doing it so hard?

What we need to know:How big is the budget gap?Where does spending go?Where does revenue come from?


How Big is the Budget Gap?

The size of the budget gap depends on several factors . . . Delay means a bigger gap to close later Tightening policy too soon could slow

recovery and make the gap worse What assumptions to make about growth,

demographics, and interest rates? How close to a balanced budget do we

need to get to ensure sustainability? As a working estimate of the budget

gap, we will use the cyclically adjusted primary deficit, about 7% of GDP in 2009. Some other estimates are larger or smaller.

The Congressional Budget Office has estimated the budget gap at 8 percent of GDP as of 2009, growing to 15 percent if no effort is made to close it before 2040


An Easy Promise: Cut Wasteful Programs

Politicians love to make the easy promise of closing the gap by cutting programs that we don’t need and that do not work

Where can we look for such programs, and how big might they be?

The Blue Dog Coalition is a group of centrist Democrats who view themselves as a voice of fiscal responsibility. Their proposals include:1.Cut programs that don’t work2.Eliminate duplication and inefficiency3.Review and terminate unnecessary federal programs

http://www.house.gov/melancon/BlueDogs/Press%20Releases/2010%20-%20Blue%20Dog%20Blueprint%20for%20Fiscal%20Reform.pdf


Nondefense discretionary spending

The first place many people look for waste is nondefense discretionary spending, which includes all programs, except defense, that are subject to annual Congressional appropriations

However, this part of the budget is surprisingly small—just 19% of all federal spending, or 4.7% of GDP, in 2010

Even cutting every bit of waste here would only make a start on closing the gap


Discretionary Expenditure by Agency

Defense spending is another 4.8% of GDP. There is waste in defense spending, too

If essential functions like federal courts, the treasury, and embassies are protected, defense spending would have to be cut by more than half, while eliminating most other departments entirely (education, labor, commerce, NASA, etc.), to close a 7% gap solely by cutting discretionary spending


Entitlements and the Budget Gap

Long-run projections show that growth of entitlement spending, especially Medicare and Medicaid, is more important than discretionary spending in explaining the U.S. federal budget gap


Excess Cost Growth of Medicare and Medicaid

Some of the increased entitlement spending is due to an aging population. That part could be reduced only if Congress were willing to cut benefits already promised to people who are retired or approaching retirement.

Another way to cut the budget gap would be to slow the excess cost growth of medical spending, that is, bring the rate of increase of medical costs down to or below the average rate of price increase for the economy as a whole


Cutting Health Care Costs: The Good News

The good news is that international comparisons show it is possible to deliver quality health care at a lower cost than in the United States

The ranking of health care systems shown here includes measurements of quality of care, access to care, efficiency, equity, and quality of life

In a recent study by The Commonwealth Fund, the US ranked lower than six other countries with less costly health care systems.

The complete Commonwealth Fund report is available at http://www.commonwealthfund.org/Content/Publications/Fund-Reports/2007/May/Mirror--Mirror-on-the-Wall--An-International-Update-on-the-Comparative-Performance-of-American-Healt.aspx


Cutting Health Care Costs: The Bad News

The bad news: Cutting health care costs is difficult. Many cost-cutting measures were proposed, but rejected, during the recent US health-care debate

Reform medical malpractice Remove tax subsidies to employer-

provided health insurance Introduce single-payer system or a public

insurance option Phase out fee-for-service payment

system and other incentives for overtreatment

Pay only for treatments that are proven to be cost effective

Source: Pdclipart.org


Closing the Gap by Raising Tax Rates

Another way to try to close the budget gap would be to raise tax rates within the current tax system

These estimates by the Urban Institute-Brookings Tax Policy Center show how much income tax rates would have to rise to cut the deficit to 2% of GDP

If only the top two rates were raised (roughly, households over $250,000 income), rates would go extremely high

The estimates are static, that is, they do not take into account any tendency for higher tax rates to cause increased efforts at tax avoidance

The complete Tax Policy Center study is available at http://www.taxpolicycenter.org/UploadedPDF/412018_seeking_revenue.pdf


Closing the Gap by Closing Loopholes and Preferences

Tax revenue could also be increased by closing loopholes and preferences, more generally known as tax expenditures

If all nonbusiness tax expenditures were eliminated, income tax revenue would be higher by about 5% of GDP—enough to close a large part of the budget gap

However, many tax expenditures serve public policy purposes, so eliminating them would have significant opportunity costs

The complete Tax Policy Center study is available at http://www.taxpolicycenter.org/UploadedPDF/1001234_tax_expenditures.pdf


Closing the Gap With a Value Added Tax

Additional revenue could be raised with a value added tax (VAT), a type of tax on sales of goods and services used by most advanced countries

Based on a study by The Tax Center, a 15% VAT could raise revenue of 3% to 6% of GDP, depending on assumptions about interaction with other taxes and whether food, housing, and medical care were excluded

The Tax Policy Center study on VAT is available at http://www.taxpolicycenter.org/UploadedPDF/412062_VAT.pdf


The Bottom Line

No single spending cut or revenue increase will be enough to to close the budget gap and ensure long-run fiscal sustainability

A combination of approaches will be needed Eliminate waste in discretionary spending Control growth of entitlement spending,

especially Medicare Raise tax rates Reduce tax loopholes and preferences Introduce new taxes like a VAT

Closing the gap will be hard. Every tax and spending line in the budget has political supporters—if not, it would not be there in the first place

“The choice facing policymakers is not whether to address rising deficits and debt but when and how to do so.” —CBO

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